In FED We Trust by David Wessel Page B

a weakening economy, the Fed began cutting interest rates aggressively in January 2001. The Fed’s target for the federal funds rate — its key interest rate, the one at which banks borrow from one another overnight — plunged from 6.5 percent at the beginning of 2001 to 3.5 percent at the time of the September 11 attacks. After the attacks, the Fed kept cutting the rate, ending 2001 at 1.75 percent. As the economy sagged and fears of Japanese-style deflation grew, the Fed later dropped the rate to a forty-five-year low of 1 percent and kept it there until June 2004.
    When the Greenspan Fed finally turned to raising interest rates, it did so at what it described as a “measured pace” — very slowly. Taking its foot off the monetary gas pedal ever so cautiously, the Fed raised the fed funds rate by only one-quarter of a percentage point every six weeks or so. The rate didn’t cross 3 percent until May 2005. Greenspan took it to 4.5 percent on his last day on the job.
    When interest rates are so low, credit is usually cheap and plentiful, and the prices of stocks, houses, and other assets tend to rise. It’s cheaper to borrow to buy assets, and the alternative — putting money in the bank or in bonds — is less attractive because returns are so low. The
Wall Street Journal
tracked this phenomenon in a 2005 front-page series called “Awash in Cash” that illustrated how in a world of cheap and plentiful credit people will pay just about anything for anything — and this was before the worst of the subprime mortgage loan craze.
    Among the examples:
A week after Hurricane Katrina, a defaulted loan backed by aging tugboats and barges in coastal Alabama came up for sale. A firm called Mooring Financial Corporation, a firm that buys troubled loans at a discount, was interested but couldn’t determine how well the boats had survived the hurricane, or even whether their cash-starved owner had kept up the insurance. So Mooringbid fifty to fifty-five cents on the dollar, and it considered that generous. The winning bidder offered about ten cents more on the dollar.
Australia’s biggest homegrown investment bank, Macquarie Bank, leased Chicago’s Skyway toll road for ninety-nine years for $1.8 billion, hundreds of millions of dollars more than some Chicago officials thought it would fetch.
An investment partnership run by Grantham, Mayo, Van Otterloo & C O. , a Boston money manager with a taste for timber, bought more than 5 percent of the land in the state of Maine.
    To be sure, Fed policy during this first part of the decade kept the economy chugging along, but there is a potential downside to sustained very low interest rates — a downside that goes far beyond overpaying for assets. As economic historian Charles Calomiris of Columbia University observed, “The most severe financial crises typically arise when rapid growth in untested financial innovations” — such as complicated securities invented to invest in mortgages — “coincided with … an abundance of the supply of credit.”
    This is exactly what happened during the last years of the Greenspan Fed. With interest rates low, investors took greater and greater risks to get higher returns. This risky investing is called “reaching for yield” — and in the mid-2000s, there was a lot of reaching. The difference between the interest rates that investors demanded on risky securities and those on the safest U.S. Treasury securities — the “spreads” or “risk premiums” — narrowed. After years of sunny economic weather, investors acted as if it would never rain again.
    Greenspan himself saw some danger. In an August 2005 speech, he cautioned, “History has not dealt kindly with the aftermath of protracted periods of low-risk premiums.” (Translation: You’re paying too much for those stocks, risky bonds, and mortgage-backed securities.) He warned, in his opaque style, that the likely scenario was that an “onset of increased investor caution